My Investment Thesis on Gaia

Feb 13, 2017 by Matt Sweeney in  Ideas

Gaia Inc (“GAIA”) is a situation where Mr. Market appears willing to pay you several million dollars to own a nichey, asset light, negative working capital, highly scalable streaming video on demand (“VOD”) business that is led by an owner operator serial entrepreneur with an enviable track record. The VOD business has reached scale and can be profitable at growth rates of ~30%, but the company is forecasting subscriber growth of 50-80% per year over the next 3 years, and funding this growth means that the business will lose money in the near term. However, this is an appropriate strategic decision that is more reflective of the vagaries of GAAP accounting than any problems with the business itself. In short, the business could be cash flow positive with the stroke of a pen by simply choosing to grow less quickly.

Admittedly this business is difficult to value, but I am quite certain it is NOT worth less than $0, the CEO has clearly demonstrated that he thinks the stock is worth more today than $7.75 per share (20+% upside from current prices), and the company believes they can achieve $60 million in pre-tax income and $2.50 per share in EPS in 2021. These are lofty goals, and investors are right to view them skeptically. However, if achieved, GAIA will likely be worth somewhere between $600 and $900 million in 2021, representing gains of 500-800% from today’s prices. Most important from my view, an investment in GAIA today comes with theoretically no down side due to cash and property on the balance sheet, making the VOD business a free lotto ticket. Notably, the value of the cash and property do not presently appear on the balance sheet preventing the automated screeners that rule the markets in an era where “stock picking is dead” from identifying the true economic value of the assets. This will change when the company releases Q3 numbers on 11/3, representing a hard catalyst.


A few short months ago GAIA reported in 2 segments, Gaiam, a branded products business focused on selling yoga related products (“yoga products”), and Gaia (formerly Gaiam TV), a money losing video on demand (“VOD”) service that has more than 7,000 titles “focused on yoga, health and longevity, seeking truth, spiritual growth and conscious films & series.” Additionally, the company owned a stake in a travel business known as Natural Habitats.

It is logical to assume that investors who owned GAIA a few months ago owned it because of the yoga products business, and were barely focused on the travel or the VOD businesses except to the extent that they were not happy that VOD was losing money.

After previously toying with a spinoff, in May the company announced that they would be selling the yoga products business for $167 million and the travel business for $12.85 million. Following the sale, the remaining company would essentially be the VOD business. We will talk more about GAIA’s founder and CEO later, but as a teaser, consider that the travel business was purchased for $600,000 in 2002, representing a CAGR of approximately 24% and indicating that the CEO is a skilled capital allocator.

Concurrent with the sales, the company announced that they would use the proceeds to finance a tender offer for 12 million company shares at a price of $7.75 per share for a total of $93 million.

The company further announced that following the completion of the sales of the yoga products and travel businesses and the tender offer for $93 million they expected to have approximately $60 million on the balance sheet.

Recent Weakness

It is important to note that legacy shareholders are left owning something they never intended to own; they thought they owned yoga products, instead they own a VOD business. This may help explain why shares have been under indiscriminate selling pressure lately. This seems especially relevant when considering the largest shareholders, several of whom are index or quant oriented. A complete change in business model by a portfolio company likely requires these holders to sell. While it is likely that they participated in the tender offer to some extent, it is possible they are presently dumping remaining shares on the open market. Additionally, management has not made any attempts to reveal the true value of their assets to shareholders, presumably because they would like to re-purchase more shares in the near future.

Hidden Asset #1

While the company intended to repurchase $93 million worth of shares, the tender offer was under subscribed, and the company was only able to deploy $74,685,572 for 9,636,848 shares and $1,368,472 for 842,114 options, which equals ~40% of the company. Curiously (deliberately?), the sale of the businesses closed on July 1, meaning that the company’s balance sheet has not been updated in the latest Q to reflect the cash from this sale. Additionally, while the tender offer fell short by $17 million dollars, the company did not update their estimate of cash on the balance sheet during a September road show. Simple math suggests that if the plan was to spend $93 million on the tender offer and have $60M cash remaining, they should now have $77M in cash, or approximately 81% of the market cap.

Hidden Asset #2

GAIA owns a building in Louisville, CO, that they purchased in January of 2008. The building sits on their balance sheet at $17.2 million (purchase price of $13.2 million plus improvements that saw it initially appear on the balance sheet for $19.4 million), and management has stated that they think it is worth, “at least $20 million.” However, I believe that this vastly underestimates the true value of the building.

Louisville is approximately 40 minutes north-west of Denver, and is just east of Boulder. The population of Colorado is growing at 2x the national average, and the Boulder area is consistently listed as one of the most desirable places to live in the United States. The population is young, educated, and highly active, which likely explains why Boulder is quickly becoming known as a technological hub, with a thriving startup community and representation from several of the big tech employers. The young, educated population attracts employers, and employers attract more young, educated people and so on.

Boulder’s geography and love of open space has created a unique real estate environment. To the west of Boulder lie the Rocky Mountains, and residents are fiercely protective of their views. Local ordinances prevent construction of buildings taller than 55 feet, and the area to the west of Boulder is insulated from development by “the blue line” which was established in 1957, and restricts water service to elevations above 5,750 feet. According to a recent article in the NY Times, the growing population and limited land open for development has led to property values rising 60% over the last 5 years.

As you may have guessed, if you can’t expand up, and you can’t expand to the west, expanding south and east become more attractive (north of course is an option as well, but south and east are considered more attractive due to their proximity to Denver and major travel corridors). According to a local real estate professional, this effect is likely to be exacerbated in the coming years because Google recently built a campus east of the traditional down town center, which will, “push the center of Boulder eastward.”

Accurately valuing commercial real estate is difficult because each building is unique, and is essentially worth what a buyer will pay for it. However, examining recent comps can be illustrative.

These properties are 2.5 miles from the building that GAIA owns and about 8.5 miles from Google’s campus.

Information on the GAIA building (about 7.5 miles from Google’s campus) is presented below, as are implied prices if the above 2 comps are applied on a P/Sq Ft basis.

There are of course several other factors to evaluate when considering if the P/Sq Ft from the comps is relevant. Of note, the first two buildings are within spitting distance of the Denver Boulder Turnpike, while the GAIA building is about 2.5 miles away. Proximity to the highway is likely regarded as attractive due to ease of access for commuting employees and delivery trucks to the extent that delivery trucks are relevant. That being said, 2.5 miles away from the highway hardly seems an insurmountable distance. Also of note, the GAIA building is quite a bit older than the comps, but the age difference is mitigated because according to local news reports from the time (since confirmed by management) the building was purchased for $13.2M, but entered on the balance sheet at $19.4, indicating that a multi-million dollar renovation was completed subsequent to the purchase. This renovation likely contributes to the GAIA property being a Class A facility as opposed to lower quality Class B facility like the comps above. The fact that the GAIA property has an onsite cafeteria and gym also likely contributes to its Class A rating. The 12.7 acre property that the GAIA building sits on is likely highly valuable as well as it includes expansive parking, as well as green spaces and the like – a must for those going for the true “campus” feel when looking for an office space, and a feature that makes this property unique in the area. As such, I think it is reasonable to think that the P/Sq Ft estimates from the recent comps are a decent starting point for valuing the building. If one then considers that the comp sales took place a year ago and commercial-office space in the Louisville area is up more than 5% YoY, something in the neighborhood of $28 million starts to sound right, and it is not difficult to make a case for something in the low-mid $30 million range when one considers the Class A rating, the size of the property, and its unique attributes.

This may sound crazy in light of the $13.2 million purchase price less than a decade ago, but there are several factors to consider that take the edge off of crazy. Notably, the 2008 10-K valued the building plus improvements at $19.4 million and notes that the company believed that the purchase price of the building was “well below its replacement value.” Examining national trends in commercial property prices as provided by Green Street Advisors from January of 2008 through today suggests that the property should have appreciated by more than 35% (January of 2008 indexed at 93.4).

35% appreciation from $19.4 million carrying valuing suggests a present value of $26.2 million, but it is highly likely that properties in the Denver – Boulder area have over indexed over the last 8 years for reasons cited previously, which suggests a 35% increase from January 2008 levels is conservative. The area has simply exploded over the last few years, as evidenced by Office Vacancy rates in Boulder County that are below 4% presently.

Further evidence that 35% appreciation is conservative comes from the fact that GAIA seems to have scored a bargain purchase price. The seller was Conoco Phillips, a $50B behemoth who was conceivably not price sensitive, and the sale took place as the housing crisis was brewing and the real estate markets were falling apart. While January 2008 purchases index at 93.4 on the Green Street Commercial Property Price Index, January 2009 purchases index at 68.2. If Conoco was eager to exit (which seems likely), they likely hit a low ball bid from GAIA. Also worth considering is that the buyer was Jirka Rysavy, founder and present CEO of GAIA, who has proven over the last few decades that he is a savvy business man & investor who likely viewed the purchase as not just an office building, but an investment. All of these considerations serve to validate suggestions from recent comp sales that the property owned by GAIA is worth substantially more than $20 million.

Streaming Video Business For Less than Free?

Combining the presumptive value of the cash that will soon be revealed on the company’s balance sheet and the assumed value of the building that the company owns reveals the implied value of the VOD business in a variety of scenarios.

Although the low case above is what the company has been touting, I consider it to be extremely conservative for the reasons laid out previously. The high case is arguably aggressive as it assumes that the VOD business will not have burned any cash in the quarter and that the building and associated real estate are trophies (although this is mitigated by the assumption that the value of the real estate is likely to continue to grow at mid-single digits for the foreseeable future). It is also worth noting that GAIA has indicated they were open to selling the building in the past and following the recent sale of the other businesses, the building is less than 20% used by GAIA, making a sale in the near term a very real possibility.

Worst Case Scenario…

When considering an investment that is essentially just a ton of cash and a building, investors are right to be skeptical. Tales of un-incentivized management teams treating their businesses as personal piggy banks, paying themselves high salaries and squandering the cash on foolish acquisitions are legion, and should be considered the worst case scenario in situations such as these. I suggest investors use this backdrop as a starting point when considering GAIA and its cash rich balance sheet. Now I suggest doing a 180 degree turn and considering the exact opposite: the best case scenario.

Following the recent sales and tender offer, GAIA is 38% owned by Jirka Rysavy, who neglected to participate in the tender offer, essentially doubling down on his investment in GAIA. Rysavy is thus clearly motivated to focus on share price. For additional evidence that Rysavy is unlikely to bleed the company, consider that this is a man who for years lived in a cabin in the woods with no electricity and no plumbing… while he was CEO of a Fortune 500 company. Suffice to say he is not driven by material trappings, but rather by entrepreneurial success, and on this front, his resume is impressive.

Rysavy came to the United States from Eastern Europe in the early 1980s with no money and a limited ability to speak English. He started a business known as Corporate Express which focused on selling recycled office products using the Walmart model (sell cheap!) as his blue print. He grew this business into a Fortune 500 company with 27,500 employees and sold it to Staples (SPLS) for $4.7 billion in 1998. During the early days of Corporate Express he also founded a natural foods store known as Crystal Market which he later sold to Wild Oats, which Whole Foods later attempted to buy. Gaiam, the predecessor company to GAIA, was also founded during the early days of Corporate Express, although Rysavy did not devote his full energy to the project until after the sale of Corporate Express. Rysavy has started and invested in several other businesses over the years, suggesting that he is a serial entrepreneur driven by business success, not money. This is an important backdrop when considering the downside case of an investment in GAIA. If we start with the assumption that the VOD business will fail, what we are left with is a highly motivated serial entrepreneur with a track record of success who has access to a pile of cash and his own skin in the game. I thus consider it highly likely that if it becomes clear that VOD is a failure, Rysavy will not continue to pour good money after bad, but will rather pivot and do something else intelligent with the cash.

The VOD Business

Having established that the market apparently thinks the VOD business is worth less than $0, it is worth considering what the market is so pessimistic about. In brief, GAIA is a globally available content provider with 170,000 existing subscribers and 7,200 hours of content, 93% of which is exclusive to GAIA. Broadly, the content falls into four categories, “yoga,” “seeking truth” (focused on metaphysics, ancient wisdom and answering the question “why are we here?”), “transformation” (focused on deepening the mind, body, spirit connection), and “films and documentaries.” The base rate for a monthly subscription is $9.95, and GAIA is available through all the major platforms like Apple TV, Roku, and Amazon, as well as to Comcast and Verizon customers. This is clearly niche content, and the company believes that in 2020 their total potential audience will be 11.5 million people, which represents 7% of the forecasted global “Over The Top” (OTT) video audience. The company presently has customers in 120 countries which represent 33% of their subscriber base. However at the moment language translation is limited, but set to expand beginning this quarter. Longer term the company believes that 60+% of their subscribers could be international. The company has in house production facilities at the previously discussed Boulder property, which contributes to them being able to keep production costs at a comparatively low 20% of revenue (vs 70% at NFLX).

At first glance, it is difficult to claim that this business has any sort of “moat” as barriers to entry appear to be limited. For example, there is nothing stopping Netflix or Amazon or others from entering the space tomorrow. The counterpoint to this however is that content of this sort is already abundant and freely available on YouTube. There are countless yoga studios that stream their content, and no shortage of people willing to soliloquize on their views of the world. Despite this broad availability, GAIA has been able to grow subscribers at rates between 30 and 90% annualized in recent history, suggesting that their content is high quality, and possibly that paying for the content imbues it with higher value. Over time it is likely that the presenters on GAIA’s platform become the moat, as subscribers develop a pseudo relationship with them. This should not be considered a deep or wide moat, but given the low stock price, existing library, proven production capabilities, and existing subscriber base, if Netflix, Amazon or other deep pocketed potential competitors wanted to enter the space, it would arguably be much easier to buy GAIA rather than build out a new offering. Additionally, Netflix and Amazon have much bigger battles to fight in the quest to become the dominant content provider, and niche content such as that provided by GAIA is likely low on their priority list.

So What is the VOD Business Worth?

As investors in NetFlix (NFLX) know, VOD can be a very attractive business. Clearly GAIA’s offering of yoga and lifestyle centric content has nowhere near the scale potential of NFLX, but the two businesses are similar in that they have tremendous embedded operating leverage, and are highly scalable. One Important positive difference between GAIA and NFLX is that while NFLX spends a fortune (~70% of revenue) on content costs, GAIA’s content costs are less than 20% of revenue, making GAIA significantly less capital intensive and allowing GAIA to benefit from negative working capital. These factors contribute to growth in revenue dropping almost directly to the bottom line, which means that pursuing growth is the right strategy for the long term, even if it can lead to operating losses in the short term. If you need further evidence that this strategy is wise, consider that it is estimated that Netflix will burn $1.2 billion in the coming year pursuing growth through marketing and content costs. Despite this massive cash burn, NFLX is awarded a 7x EV/Trailing Sales multiple by the markets, while GAIA trades at ~1x EV/Trailing Sales (excluding real estate), despite the fact that it is likely to grow more than 2x as fast as NFLX in the coming year.

VOD – Asset Value

The company has more than 7,200 hours of content, and production costs presently hover around $5,000 per hour of content. Replacement value would thus equal $36 million, but this type of content is essentially worth whatever someone will pay for it, and we can’t know in advance how much that is. For skeptics that might think this nichey content is worthless, consider that people want and actively acquire all sorts of content. For example, CONtv is a streaming network focused on “comic conventions.” That’s right. A dedicated streaming network focused on people who like to dress up in costumes and pretend they are super heroes. On days other than Halloween. In the interest of conservatism, it is appropriate to assume a discount to production cost of somewhere between 60 and 40%.

I believe that these numbers are a reasonable representation of what GAIA would look like in a liquidation scenario, suggesting that even under pessimistic assumptions downside is negligible.

VOD – Theoretical Steady State

Valuing the VOD business as a going concern is no easy task. Skeptics will claim that at present GAIA resembles a venture capital investment following a fund raising round, where the risk is that the company will quickly burn through cash. There may be some legitimacy to this fear, although as discussed previously, this risk is tempered by the fact that nobody has more to lose than the skilled capital allocator at the helm. Perhaps more importantly though, the company has proven that the VOD business – which will lose money in the near term – could be profitable right now if they so choose. In fact, the business broke even in Q2 2015 and was profitable in Q3 2015 at run rate revenues of ~$14.5 million, while growing subscribers 30-35%. Profitability was a deliberate decision made by the company in advance of the contemplated spin-off between VOD and the yoga products business which was meant to isolate their respective values. According to the company, growth levels of 30-35% which would allow the company to be currently profitable require spending approximately 25% of a customer’s life time value on marketing.

However, the company does not plan to be profitable in the near term because they plan on ramping up marketing spend in order to return to subscriber growth rates of 50-85% per year, which they hit in 2014. According to the company, growing at this rate requires spending half of a customer’s life time value on marketing. In my view, aiming for this incredibly rapid growth is a bold decision that could only be made by an owner operator who is more concerned with long term value than pleasing Wall Street analysts in the short term. Additionally, it is worth noting that Rysavy has indicated that they never spend more than half of a customer’s life time value, which further insulates against the risk that the company will simply burn through their cash pile.

To understand the relationship between growth and short term profitability at GAIA, consider that under GAAP accounting, rapid revenue growth in a subscription business fuels near term operating losses, and thus topline growth – obviously a long term positive – is a negative contributor to the company’s earnings in the short term. This is because under GAAP, customer acquisition costs must be expensed immediately, while revenue from new customers is only recognized ratably. In simple terms with illustrative numbers, if a customer costs $50 to acquire, and spends $10 per month on a service once acquired, in the first quarter after the customer signs up the income statement will show revenue of $30, and cost of $50, for a loss of $20. However, the true value of the customer is not represented by this loss of $20, but rather by the present value of the revenue they generate over their lifetime. If a customer spends $10 a month for 12 months, revenue attached to this customer is obviously $120, while expense attached to this customer is $50, for a gain of $70. Rysavy himself has commented on this reality:

If you breakeven you can grow like 20% to 30%. Anything over that did, it’s investing into the new customers, because we don’t capitalize the customer so all the hits from the market [subtract]. So it — too much anything over like that 20% to 30% would take from the P&L.
– Jirka Rysavy, CEO – Q4 2015 conference call

As such, accurately valuing the business and its future growth requires investors to step away from the confines of GAAP and consider duration of subscription and customer churn. This is just common sense, but common sense is uncommon on Wall Street. Importantly for investors, the computer driven investing models that dominate the markets these days are incapable of making common sense distinctions when screening for stocks to buy, which helps explain why this opportunity exists.

The company does not fully disclose information on how long customers stick with the product or churn rates, but based on the company’s profitability in mid-2015, recent subscriber growth, and the company’s claims that new customers have 85% cash contribution margin, we can estimate what the business would look like today if they were to abandon plans to grow at 50-85% per year and focus on current profitability.

The company has indicated that in mid-2015 they were able to run-rate at $1 million in EBITDA (which in a capital light, debt free business with NOLs is a fair approximation for cash) with ~120,000 subscribers. Since then the company has added more than 50,000 subscribers who are presumably generating $100 in revenue per year.

Note that in mid-2015 when the company was profitable they were still growing subs over 25%, but for our purposes here we are calling this “steady state,” which should add an additional margin of safety. For reference and comic relief, consider that NetFlix trades at an EV/EBITDA of 160x. Clearly GAIA is not NFLX and will never trade at the same multiples, but the high side estimate of 12x vs. 160x seems sufficiently punitive to account for GAIA’s smaller total addressable market and smaller size, especially when one considers that at present GAIA has a customer relationship with less than 1.5% of their total addressable market, while NFLX has already accessed 25% of their total addressable market (estimates vary).

VOD – Growth Potential

Accurately predicting GAIA’s future would require perfect knowledge of customer acquisition costs, customer growth rates, churn rates, and duration, none of which are available to investors. Even with this information, it would be impossible to accurately forecast several years in the future. What is important is that whatever growth potential GAIA might have is free to current investors, yet it is likely to be very valuable. On a macro level, it seems clear that the trend toward Over The Top (OTT) television is only gaining speed. Additionally, there is a clear trend toward more nichey content and increasing evidence that consumers are willing to pay for it – for example, 60% of NFLX subscribers subscribe to more than 1 streaming platform, with 18% of households subscribing to 3 or more platforms.

A GAIA initiated marketing study suggests that by 2020 there will be 300 million OTT subscribing households globally, with 165 million of those households interested in at least one GAIA topic. Of that 165 million, the company believes their total addressable market (TAM) is 11.5 million, or 7%. As of their most recent investor presentation, the company has set a goal of 1 million subscribers in 2019, and 1.6 million in 2021. To achieve these numbers, the company has forecasted growth of 50%, 80% and 80% in 2016, 2017 and 2018. According to the company, reaching these levels of growth requires spending approximately half of a customer’s life time value on marketing. Based on these estimates through 2018, we can estimate what the company believes growth may look like through 2021.

On their face, these numbers are obviously aggressive. However, the company is starting from a low base, is only now beginning to roll out foreign language service, and has proven they can grow at high rates in the past. For example, as of Q1 2016, the company was growing at a 90% annualized rate, well above their target of 50% for the year.

1.6 million subscribers is about 14% of what they have identified as their TAM which seems reasonable, if not conservative. For reference, the WWE (WWE) professional wrestling network currently has around 1.5 million subscribers. It seems reasonable to assume that globally there are more people interested in yoga and “seeking truth” than professional wrestling, although it is also likely they are less rabid than WWE fans.

If the company is able to reach 1.6 million subscribers, they believe they will achieve 85% gross margin, 90% cash contribution margin, and 40% pre-tax margin, which will generate $60 million in pre-tax income and $2.50 per share in earnings. Capital light, negative working capital businesses demand high multiples, even before considering growth, so I think P/E multiples in the range of 20-25x, implying a stock price of $50-62.50, are appropriate.

It is far from certain if the company can achieve these goals, and if they can, it will no doubt be a bumpy ride beset by setbacks. What is more certain however, is that at current prices investors are not paying for this potential growth, and in fact are arguably being paid to expose themselves to this potential growth.


GAIA is an investment opportunity with an extremely skewed risk/reward profile. The risk is protected by hard assets controlled by a clearly incentivized owner operator with an impressive track record, and the upside reward is the potential for 900% appreciation over the next 5 years. Importantly, this investment could be a success today if the company simply chose to reduce their growth rates.


– Competition from deep-pocketed new entrants
– Failure to rein in spending if it becomes clear that the growth strategy is not working

The above post has been excerpted from a recent letter of Laughing Water Capital.


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My Investment Thesis on Credit Acceptance

Feb 22, 2016

Investment Thesis

  • CACC is a defensive business with a very solid moat, good growth prospects, and great capital allocation. I don’t think the multiple reflects those qualities – the stock is undervalued
  • CACC trades at a low multiple despite delivering high growth and compounding capital at high rates
    • CACC trades at a ~9.1% forward earnings yield on an earnings stream that should grow at least in the mid-teens for the next 4-5 years
    • CACC has produced mid-teen ROICs for 20 years and continues to deliver returns in line with historical norms while operating in a near-trough pricing environment, suggesting upside to earnings
  • CACC will beat sell-side estimates for NTM earnings given trends in unit growth and pricing
    • They grew unit volumes 40% YoY in Q3 & 33% in Q4, but growth expectations are very modest: those volumes will translate to earnings above expectations for the next two years as CACC collects
    • CACC is also underwriting business profitably but is doing so at the low end of its historical rates of return, suggesting that current earnings are not representative of the business’s true earnings power
  • Potential Risks:
    • Concerns around CACC approaching full market penetration are overstated
    • There is regulatory risk, but the potential impact to profitability will likely be marginal, not existential
  • In a conservative base case, I think CACC should trade at ~$305 or ~50% above current value
    • In a bear case, I see limited downside given attractive entry multiple, defensiveness, and continued growth at above market rates: over the long term, CACC should outperform. But, if the auto cycle turns meaningfully negative, CACC could face temporary growth challenges or increased provisions

Valuation Methodology

  • In a conservative base case (key assumptions & drivers are below,) and a modest multiple for a business growing at least in the mid-teens, I arrive at a value of ~$305/sh.
    • I use 15x FY1 EPS – a premium to the current multiple but still cheap given per sh growth prospects
    • Given growth, defensiveness, and market position, I think a 10% discount rate is adequate

Mike Miller - CACC(17)

Key Metrics Summary
Mike Miller - CACC(17)

Business/Market Overview & Investment Rationale

Business & Market Overview

  • The auto finance market is large, fragmented, and for most companies, very competitive
    • Most lenders operate in a highly competitive landscape, bidding for business around clear market rates of return based on varying risk profiles
    • CACC is well positioned competitively vs. both subscale and established lenders
  • The market is also highly cyclical, but CACC has a long history of underwriting discipline
    • The auto loan industry has gone through multiple cycles, starting in the early 90s after CACC’s IPO
    • CACC has been affected by market cycles, but it has effectively priced its business throughout cycles
      • CACC can do this because they operate a unique lending model with limited competition

Key Investment Drivers

  • Dealer holdback is a profitable, differentiated model
    • CACC’s model aligns interest between the dealer and the lender, resulting in improved credit quality
    • Without real competition, CACC has pricing power, driving attractive ROAs & ROEs
  • CACC’s model is much more profitable than peers and requires less leverage
    • CACC has a consistent history of delivering attractive ROAs & ROEs but other lenders do not
    • Peers trade at bad multiples, reflecting the risk associated with their highly leveraged earnings stream, which I believe weighs on CACC’s multiple while CACC is very conservatively financed
  • With current spreads (CACC’s pricing on their loans) near historical lows, LTM earnings understate the true earnings power of the business
    • Spreads are below their historical norms suggesting CACC’s earnings power isn’t fully reflected in recent results
    • In addition, recent growth has been very positive, well above that of the past 3 years, which if it continues, would drive considerable earnings outperformance
  • CACC is highly cash generative & deploys capital effectively – driving superb results on a per share basis
    • FCF doesn’t reflect true cash generation capability because of high degrees of reinvestment
    • Aggressive buybacks (1/2 the shares since 2001) amplify already attractive ROEs and should continue to drive well above market EPS growth
  • Attractive reinvestment opportunities over the next 3-5 years: unclear how long the runway will be in the long term but outcomes skew positively
    • CACC has ample near-term runway to grow – it’s long-term runway will be an inverse function of credit availability in subprime
    • But given that the size of CACC’s TAM is inversely correlated to the profitability of low ROA, highly leveraged peers, I think outcomes skew positively over the long term
  • Regulatory risk is real, but the company is prepared, the product is valuable – the market appears to have overcorrected
    • CFPB focus will likely increase costs, not eliminate the business
    • CACC is well positioned relative to peers to deal with the potential of more stringent regulation

Mike Miller - CACC(18)

The Auto Finance Market is Large, Fragmented, And For Most Companies, Very Competitive

  • The market for US auto financing is huge (~$1 trillion dollars) and relatively fragmented, particularly in used car lending
    • ~60% of auto loans are for used vehicles
    • ~20% of total loans taken are subprime (<600 FICO) or deep subprime (<500 FICO)
      • The market for subprime and deep subprime are ~$160Bn and ~$36Bn, respectively (Q3 2015)
  • Credit Acceptance represents a very small portion of the market, providing <2% of total used auto loans and ~2% of the total loan volume for subprime and deep subprime

Mike Miller - CACC(19)Mike Miller - CACC(19)

  • Most lenders operate in a highly competitive landscape, bidding for business around clear market rates of return based on varying risk profiles
    • Competitive risk-adjusted rates of return have pressured ROAs for CACC’s competition

Mike Miller - CACC(19)

  • CACC is well positioned competitively vs. both subscale and established lenders
    • As the regulatory landscape evolves, compliance costs will pressure the margins of smaller players, many of whom are in-house financing arms at dealerships (that don’t report to agencies)
    • In addition to regulatory pressure, rising rates will pressure NIMs for CACC’s established competitors, who have much lower ROAs, potentially increasing the demand for CACC’s loans

Mike Miller - CACC(19)

The Auto Finance Market is Highly Cyclical; However, CACC Has a Long History of Underwriting Discipline and Collections Execution

  • The auto loan industry has gone through multiple cycles, starting in the early 90s after CACC’s
    IPO and profitability attracted more capital to the space

Mike Miller - CACC(20)

  • And while CACC has been affected by market cycles, it has effectively anticipated its ability to collect on its loans
    • In the past 22 years, CACC has only overestimated collections by more than 2% on two occasions: 2001 and 2007 (reported collections of 95.6% and 96.2% of expectations, respectively)

Mike Miller - CACC(20)

Note: Before 2001, the maximum reported collection was 100%, so the average is understated.

Mike Miller - CACC(20)

Dealer Holdback is a Profitable, Differentiated Model

  • Most lenders underwrite by bidding against one another in competitive auctions; after underwriting, the dealer is removed from the equation. This is problematic because:
    • The dealer has no economic incentive to put the customer in a car he/she can afford
    • Traditional underwriting is very competitive, which results in subpar returns on assets
      • With low ROAs, lenders have to employ significant leverage to generate attractive ROEs, which in a cyclical industry, can be dangerous
  • CACC has a unique model that aligns its interests with dealers, reducing credit risk on its loans
    • CACC provides an advance on the amount financed (principal + interest) to the dealer, which covers the cost of sale and provides a small profit. CACC provides that advance in exchange for the right to collect a 20% servicing fee on the total collections balance
    • From the dealer’s perspective, there is an immediate profit, net of the vehicle expense, but most of the dealer’s return comes from the customer’s payments on their loan (called holdback)
      • The dealer is therefore highly incentivized to put the consumer in a car he/she can afford

Mike Miller - CACC(21)Mike Miller - CACC(21)Mike Miller - CACC(21)

  • CACC benefits from a significant incumbent bias and effectively no competition
    • CACC is in effect the lender of last resort – they step in for the portion of the population that traditional lenders fail to address. This is a very difficult position to disrupt
    • Because most of the dealer’s profit is based on a promise – that CACC will service the loan and make payments to the dealer – there is little incentive to move to an unproven player
  • As a lender of last resort, CACC has control over its pricing, which drives above-market IRRs and ROAs on a risk-adjusted basis
    • CACC is exposed to the auto cycle to some extent because the size & profitability of their underwriting universe is effectively the vacuum created by traditional lenders
    • Within that space, CACC has demonstrated the ability to underwrite profitably for ~30 years

Mike Miller - CACC(21)
Mike Miller - CACC(21)

CACC’s Model is More Profitable Than Peers and Requires Less Leverage

  • CACC has a consistent history of delivering attractive rates of return on both total capital and equity capital but other lenders do not
    • The competitive dynamics of the underwriting process have not been favorable to most lending companies, but CACC has underwritten profitably throughout the majority of its history
    • CACC is very conservatively financed with both 1) diverse funding sources spread out over various maturity durations and 2) significant excess borrowing capacity on many facilities

Mike Miller - CACC(22)Mike Miller - CACC(22)

  • With subpar ROAs, competitors employ significant leverage to deliver favorable ROEs
    • I see the combination of leverage and cyclicality in the subprime market is dangerous for CACC’s competitors, which over time, should create opportunities for CACC

Mike Miller - CACC(22)Mike Miller - CACC(22)

  • However, applying so much leverage to a space that has been highly cyclical puts those earnings at risk, which is reflected in the multiple
    • I believe the poor earnings quality of peers and the associated multiple weighs on CACC’s multiple
    • While most of CACC’s peers’ earnings are peaking and decelerating, CACC’s rates of profitability are neartrough and accelerating – I don’t think CACC’s premium multiple reflects that dynamic fully

Mike Miller - CACC(22)Mike Miller - CACC(22)

With Current Spreads Near Historical Lows, LTM Earnings Understate the True Earnings Power of the Business

  • Spreads, which are a proxy for CACC’s IRR on a loan, are currently below their historical norm
    • Spreads have been somewhat volatile but typically trend within 3% of the mean
    • The spread (return) CACC can deliver on its capital is typically an inverse function of the ease of credit in subprime

Mike Miller - CACC(23)

  • At current spreads, a 400bps improvement in CACC’s incremental spreads (a return to the mean) would result in a 12% improvement in earnings power
    • Spreads have been somewhat volatile but typically trend within 3% of the mean
    • Operating leverage has put downward pressure on spreads (CACC can now write more business at lower rates to the same level of profitability,) but trends still suggest the business is under earning
  • In addition, recent trends demonstrate that growth is not slowing but accelerating, which provides visibility to further earnings upside

Mike Miller - CACC(23)Mike Miller - CACC(23)

CACC is Highly Cash Generative & Deploys Capital Effectively – Driving Superb Results on a Per Share Basis

  • CACC has there uses for its cash flow, providing substantial flexibility in FCF deployment
    • 1. Underwriting: Extending advances to dealers – the core business
    • 2. Loan Purchases: Buying existing loans and servicing them (done when returns are attractive)
    • 3. Buybacks: CACC evaluates all capital decisions vs. the expected return of buying back their stock
  • CACC’s FCF conversion appears weak, but only because so much capital is reinvested to grow the business: steady state FCF conversion would be close to 80%, implying ~30% FCF margins

Mike Miller - CACC(24)

  • These three uses of cash present different return opportunities depending on the market environment, and CACC has demonstrated the ability to effectively redeploy its FCF
    • CACC’s flexibility in FCF deployment is one of its most important competitive advantages
  • Capital allocation track record demonstrated in EPS growth and buybacks
    • CACC has bought back 50% of their stock since 2001

Mike Miller - CACC(24)Mike Miller - CACC(24)

Attractive Reinvestment Opportunities Over the Next 3-5 Years: Unclear How Long the Runway Will be in the Long Term but Outcomes Skew Positively

  • Given the size and fragmentation of the industry, CACC still has growth ahead of it at <2% market share for used car loans
    • The market for subprime and deep subprime finance (below 600 FICO score) is currently ~$200Bn or 50x of CACC’s current book of business (~$4Bn)
      • From this perspective CACC’s runway seems very, very long
      • A snapshot of the 2013 subprime ABS market demonstrates how small a share of total volumes CACC represents and how important the continued profitability of Santander, Ally, and other highly leveraged peers is to shaping CACC’s market opportunity

Mike Miller - CACC(25)

  • But eventually, the pace at which CACC adds dealers will decline as they approach full market penetration; however, there is ample runway in the near term from this perspective
    • The number of dealers matters because it is through the dealers that CACC distributes their product
    • CACC currently has ~8mm dealers on their network; that is out of a total market of dealers of ~55k
    • Mgmt points to 55k as their TAM, but the real number is probably closer to 30-50% of that, proportional to the nonprime & subprime market
      • That suggests CACC can only double the dealer base 1-2x, assuming attrition – more than enough runway for the next few years
  • Offsetting the eventual trend in slowing active dealer growth, growth in volume/active dealer should improve over time
    • These volumes should grow above the market for used vehicles, driving topline growth
    • Volume/active dealer is highest in markets where CACC has operated the longest, demonstrating the value of the product and accelerating utilization over time
  • The full market penetration is a moving target because the size of CACC’s addressable market will fluctuate with the credit environment
    • Given that CACC’s value proposition of guaranteed credit approval, the size of their market will grow in periods of contracting credit

Mike Miller - CACC(25)

Regulatory Risk is Real, but the Company is Prepared & the Product, Valuable

  • CFPB focus will likely increase costs, not eliminate the business
    • This is a high value product – people need cars in America, and, in addition, CACC is one of the few lenders who offer deep subprime borrowers the opportunity to rebuild their credit
      • I see the CFPB closing access to subprime auto financing as unlikely in a nation where you literally cannot live without a car in many geographies
    • The criteria for aggressive lending that have been previously scrutinized center around uncollateralized, rollover installment loans – not straight-forward, asset backed finance
  • Equifax, an unbiased but influential industry player, recently articulated the importance of subprime lending in a study on the industry
    • They also note the dangers of potentially restricting the current industry, which could result in less reliable (and potentially dangerous) sources of credit for consumers in need

Mike Miller - CACC(26)

  • Regulation, therefore, will likely influence CACC’s cost structure more than its model but robust compliance is already a part of the business
    • Having operated in nation-wide collections for years – and collections is a very regulatory-intensive industry – CACC has significant experience in working constructively with regulators
    • Paired with their scale and anticipation of more scrutiny, their model should prove durable to change
  • CACC is well positioned relative to peers to deal with the potential of more stringent regulation
    • If the space were regulated, ROEs for CACC could be pressured, but regulation would push lower ROA lenders out of business.
      • CACC is the only operator who could potentially sacrifice profitability for volume (although they haven’t before), and are therefore the most resilient to regulatory change
      • Small dealers that offer in-house financing or other small lenders (who collectively represent a considerable portion of the subprime market) do not report to the credit bureaus and would be more likely targets of regulation
  • Increased regulatory scrutiny could actually benefit CACC by impairing margins for subscale or lower ROA competition, forcing those firms to withdraw products, increasing CACC’s TAM

Mike Miller - CACC(26)


Dealer Interviews: Key Takeaways

Background: These are notes from my conversations with dealers following my write-up, which was based on public information and conversations with CACC IR. I had ~25 conversations in total, and ~15 of them were very substantive, meaning I had the opportunity to ask all of my questions.

Confirmed Assumptions

  • (+/-) MARKET IS VERY COMPETITIVE FOR LOANS: Choosing a lender is a very economic decision. Dealers have tons of options. Dealers need CACC when they can’t get financing done through typical providers
    • For most lenders the process is hyper competitive – some have 20+ financing partners
    • Dealers think very hard about the value proposition of their financing partners
  • (+) BUT WITH THE HOLDBACK, BRAND/TRUST MATTER & CACC DOMINATES: CACC is a very good operator and their brand is valuable. The importance of trust, speed of execution, and collections reliability really matters when using the holdback approach (dealers won’t get paid for 1-2 YEARS later, so the promise from CACC is important)
    • CACC has a significant advantage in the holdback market in brand value and pricing
    • Trust, speed of payment, and pricing. On brand value, CACC appears to be the most trusted name, with
    • Westlake coming in second, then a new company called Go in 3rd
    • CACC pays the fastest and offers the best pricing for depending on inventory
    • Generational bias towards CACC (old dealers love them) – this may be a long-term risk

New Insights

  • (+) STICKYNESS: CACC’s program model has significant influence on a dealership and improves retention: there is a training program and a buying protocol
  • (+/-) PROFITABLE IN ANY MARKET: In any market, the CACC program is profitable, but in very loose credit markets, some dealers think they have a better return on time by working with full credit providers (SC, Ally, WFC, etc.) because they can sell vehicle at higher margins
  • (+/-) INVENTORY & COLLATERAL VALUE: A key issue I was unaware of is the importance of appropriate inventory: CACC requires that the dealers buy vehicles below average book value to ensure collateral value (and minimize their credit risk). Matching your inventory to CACC’s program (cheap, US sedans) is essential: this results in a safer transaction for all parties and ensures the customer gets value in his/her purchase.
    • The dealer needs reliable cars, quality vehicles, bought below book (because CACC won’t extend an advance much in excess of book value) to ensure they’ll last the life of the loan
    • In addition to the incentive alignment, the experience is very controlled and ALL PARTIES reduce their risk as much as possible, including the customer
    • CACC creates margin of safety for the collateral value by controlling the buying habits of its dealers: this is unique and reduces CACC’s downside risk materially
      • CACC determines the type of inventory, the price you buy, and the price you sell
    • This model can be limited if you operate in an SUV market, where prices are higher
  • (+/-) NEED FOR HIGH VOLUME: If you are not doing a lot of volume, it’s not worth the effort to participate because CACC sales are lower margin than fully financed auto sales. This can lead to dealer attrition, particularly for marginal dealers, if volumes can’t meet the fixed costs of working with CACC. Smaller dealers have a preference for Westlake or Go.

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What Concerns Me About CafePress

Feb 23, 2016

We sold half of our position in CafePress.  The reason for this is we are concerned management may not be able to successfully grow the business and because of that reduced visibility, it should be a smaller percentage of the fund.  In the most recent quarter CafePress reported its revenues decreased 30 percent compared to the prior year.  We expected revenues to decline when management stopped using unprofitable promotions and discounts to spur demand but the decrease was greater than we anticipated.

If you recall, the co-founders of CafePress returned in 2014 to turn around the business, planning to first stabilize the business, second optimize it, and third grow the business.  So far the co-founders have been able to stabilize and simplify the business by cutting over 200 product types, leaving CafePress with its 400 best-performing products.  This has resulted in improved gross margins of 40 percent, simplified operations, and improved free cash flows (free cash flow burn rate in the most recent third quarter was $0.8 million compared to $4.9 million in the previous year).  The co-founders are now focused on the second stage of the turnaround which is the optimization phase which can be best described as the phase where the infrastructure is built to grow the business.  For example, CafePress is making investments in engineering and human resources.  Although we appreciate the fact that the co-founders are reinvesting in order to grow, we are less enthusiastic about the fact that they are hiring new leaders from outside the business, which we believe increases risk.

We also believe its primary competitor Zazzle has a better website and better products and have been unimpressed so far with the changes made to the CafePress website and product offerings.  All these factors mean that we find ourselves in the position of not being able to forecast what this business will look like in the next five years which means it should represent a smaller percentage of the fund.

Although reduced, CafePress still represents 5 percent of our fund as of the end of the year.  One of the main reasons we have not reduced our position further is that most of our purchases were made in February of 2015 and we are waiting until February 2016 in order to classify our taxable gains as long-term.  In the interim we believe our downside is protected from the $2.60 per share in cash on the balance sheet as of the end of the third quarter (stock price at end of year is $3.84 per share).

This post has been excerpted from a letter to partners of Compound Money Fund, LP.

This document is for informational purposes only. It is intended only for the person to whom it has been delivered. This document is confidential and may not be distributed without the express consent of Time Value of Money, LP. The information contained herein is subject to change; however, we are under no obligation to amend or supplement this document. This document is not intended to constitute legal, tax, or accounting advice or investment recommendations. This document shall not constitute an offer to sell or the solicitation of an offer to buy nor shall there be any sale of a security in any jurisdiction where such offer, solicitation or sale would be unlawful prior to issuance of an offering memorandum. An investment in Compound Money Fund, LP involves a substantial amount of risk. Investments should only be made by investors who fully understand these risks and can withstand a loss of their entire investment.

Strayer Education: A Mistake?

Feb 23, 2016

We reduced our holding in Strayer Education from 14.1 percent of the portfolio at the end of the third quarter to 5 percent at the end of the year.  We believe Strayer has lower growth prospects and as a result trades at a fair valuation.  It therefore represented too high a percentage of the portfolio at 14.1 percent.  We believe it is more prudent to remain on the sidelines and wait to see if growth begins to materialize before committing a larger percentage of our portfolio to this position.

We also do not see any short-term catalysts on the horizon. We examined job growth prospects in the markets where Strayer’s students are located such as Washington, D.C. and Virginia, and saw no dramatic near term job growth that would drive prospective student enrollment within the most common degree plans at Strayer.

We have also become increasingly concerned that the employee culture is exhibiting signs of decline as the leadership continues to emphasize cutting costs instead of growing the business.  This is placing pressure on existing employees as many are being asked to take on more work.  For example, full-time faculty members are being asked to teach more classes.  Also, many support positions have been eliminated which we believe may have an effect on service quality.  We believe layoffs can profoundly affect the culture of the business, spreading fear among the remaining employees in the organization.  This fear causes companies to contract rather than expand.

Is Strayer a mistake?

As many of you know I have been a champion of Strayer for many years, writing at length in past quarterly letters about the strength of the investment.   My investment thesis was based on the fact that Strayer was the best run for-profit education institution and it avoided the bad practices of other for-profit colleges, such as recruiting students with false promises and loading them up with debt they could not pay back.  I felt many of Strayer’s problems were industry related and that its stock price would recover as investors discovered Strayer did not engage in the same practices as other for-profit schools.

Then employment growth in the United States began to decline and this along with other factors caused new student enrollments to decline by double digits.  This had the effect of shrinking Strayer’s total enrollment from 60,000 students at the end of 2010 to 42,200 students as of the most recent quarter. I had underestimated how quickly enrollments would decline but did not want to react too quickly to the negative news and sell the position. As new student enrollment stabilized in the last year, this gave me further confidence to continue holding our position.  We also gave Strayer credit for proactively seeking new avenues of growth such as their deal with Fiat Chrysler and the new Jack Welch Executive MBA program.  Fiat Chrysler is paying 100 percent of the tuition for dealership employees and Jack Welch Executive MBA enrollments are growing at a double digit rate, both creating more value.  In other words, we thought that their positive steps were balancing the stagnant enrollment environment.

I believe in some respects this investment has been a mistake.  First, I succumbed to the dreaded enemy of all investors – the confirmation bias.  This is the bias which causes investors to stick to their existing beliefs.  I found myself in a position where I was defending this investment, instead of making a detached evaluation.   As we invested in higher quality faster growing businesses my comparisons changed and therefore our decision to reduce our position became clearer.

I continue to have some conviction in Strayer but believe the negative attributes may outweigh the positive attributes.  This is why I reduced the position size.  Strayer continues to trade at a double digit free cash flow yield and has an even stronger balance sheet now that it has repaid all of its debt which protects our downside.

This post has been excerpted from a letter to partners of Compound Money Fund, LP.

This document is for informational purposes only. It is intended only for the person to whom it has been delivered. This document is confidential and may not be distributed without the express consent of Time Value of Money, LP. The information contained herein is subject to change; however, we are under no obligation to amend or supplement this document. This document is not intended to constitute legal, tax, or accounting advice or investment recommendations. This document shall not constitute an offer to sell or the solicitation of an offer to buy nor shall there be any sale of a security in any jurisdiction where such offer, solicitation or sale would be unlawful prior to issuance of an offering memorandum. An investment in Compound Money Fund, LP involves a substantial amount of risk. Investments should only be made by investors who fully understand these risks and can withstand a loss of their entire investment.

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